This blog is a commentary on contemporary business, politics, economics, society, and culture, based on the values of Reason, Rational Self-Interest, and Laissez-Faire Capitalism. Its intellectual foundations are Ayn Rand's philosophy of Objectivism and the theory of the Austrian and British Classical schools of economics as expressed in the writings of Mises, Böhm-Bawerk, Menger, Ricardo, Smith, James and John Stuart Mill, Bastiat, and Hazlitt, and in my own writings.

Wednesday, May 17, 2006

Platonic Competition, Part I

The following essay originally appeared in Ayn Rand’s The Objectivist, vol. 7, nos. 8 and 9, August and September, 1968. The doctrine of “pure and perfect competition” is a central element both in contemporary economic theory and in the practice of the Anti-Trust Division of the Department of Justice. “Pure and perfect competition” is the standard by which contemporary economic theorists and Justice Department lawyers decide whether an industry is “competitive” or “monopolistic,” and what to do about it if they find that it is not “competitive.”

“Pure and perfect competition” is totally unlike anything one normally means by the term “competition.” Normally, one thinks of competition as denoting a rivalry among producers, in which each producer strives to match or exceed the performance of other producers. This is not what “pure and perfect competition” means. Indeed, the existence of rivalry, of competition as it is normally understood, is incompatible with “pure and perfect competition.” If that is difficult to believe, consider the following passage in a widely used economics textbook by Professor Richard Leftwich:

“By way of contrast, intense rivalry may exist between two automobile agencies or between two filling stations in the same city. One seller’s actions influence the market of the other; consequently, pure competition does not exist in this case.” (Richard H. Leftwich and Ross D. Eckert, The Price System and Resource Allocation, 9th ed., The Dryden Press, Chicago, 1985, p. 41.)

While competition as normally, and properly, understood rests on a base of individualism, the base of “pure and perfect competition” is collectivism. Competition, properly so-called, rests on the activity of separate, independent individuals owning and exchanging private property in the pursuit of their self-interest. It arises when two or more such individuals become rivals for the same trade. The concept of “pure and perfect competition,” however, proceeds from an ideology that obliterates the existence of individuals, of private property, and of exchange. It is the product of an approach to economics based on what Ayn Rand has characterized as the “tribal premise.” (Ayn Rand, Capitalism: The Unknown Ideal, The New American Library, New York, 1966, p. 7.)

The tribal premise dominates contemporary economic theory, and is, as Miss Rand writes, “shared by the enemies and the champions of capitalism alike . . .” The link between the concept of “pure and perfect competition” and the tribal concept of man, is a tribal concept of property, of price and of cost.

According to contemporary economics, no property is to be regarded as really private. At most, property is supposedly held in trusteeship for its alleged true owner, “society” or the “consumers.” “Society,” it is alleged, has a right to the property of every producer and suffers him to continue as owner only so long as “society” receives what it or its professorial spokesmen consider to be the maximum possible benefit. As Professor C. E. Ferguson, a supporter of the “pure and perfect competition” doctrine, declares in his textbook: “At any point in time a society possesses a pool of resources either individually or collectively owned, depending upon the political organization of the society in question. From a social point of view the objective of economic activity is to get as much as possible from this existing pool of resources.” (C. E. Ferguson, Micro-economic Theory, 5th ed., Richard D. Irwin, Inc., Homewood, Illinois, 1980, pp. 173f.)

According to the tribal concept of property, “society” has a right to one hundred percent of every seller’s inventory and to the benefit of one hundred percent use of his plant and equipment. The exercise of this alleged right is to be limited only by the consideration of “society’s” alleged alternative needs. Thus, a producer should retain some portion of his inventory only if it will serve a greater need of “society” in the future than in the present. He should produce at less than one hundred percent of capacity only to the extent that “society’s” labor, materials and fuel, which he would require, are held to be more urgently needed in another line of production.

The ideal of contemporary economics—advanced half as an imaginary construct and half as a description of reality, with no way of distinguishing between the two—is the contradictory notion of a private-enterprise, capitalist economy in which producers would act just as a socialist dictator would wish them to act, but without having to be forced to do so. (For an account of the origins of this alleged ideal, see Ludwig von Mises, Human Action, 3rd ed. rev., Henry Regnery, Chicago, 1966, pp. 689-693.) In accordance with this “ideal,” contemporary economics tears the concepts of price and cost from the context of individuals engaged in the free exchange of private property, and twists them to fit the perspective of a socialist dictator. It views the system of prices and costs as the means by which producers in a capitalist economy can be led to provide “society” with the optimum use and “allocation” of its “resources.”

A price is viewed not as the payment received by a seller in the free exchange of his private property, but as a means of rationing his products among those members of “society” or the “sovereign consumers” who happen to desire them. Prices are justified on the grounds that they are a means of rationing, superior to the issuance of coupons and priorities by the government. Indeed, rationing itself is described by Professor George Stigler, in his popular textbook, as “non-price rationing,” prices allegedly being the form of rationing that exists under capitalism. (George J. Stigler, The Theory of Price, rev. ed., The Macmillan Company, New York, 1952, p. 83.)

Similarly, a cost, according to contemporary economics, is not an outlay of money made by a buyer to obtain goods or services through free exchange, but the value of the most important alternative goods or services “society” must forego by virtue of obtaining any particular good or service. On this point, Professor Ferguson writes:

“The social cost of using a bundle of resources to produce a unit of commodity X is the number of units of commodity Y that must be sacrificed in the process. Resources are used to produce both X and Y (and all other commodities). Those resources used in X production cannot be used to produce Y or any other commodity. To use a popular wartime example, devoting more resources to the production of guns means using fewer resources to produce butter. The social cost of guns is the amount of butter foregone.” (Ferguson, op. cit., p. 173.)

On the basis of this concept of cost, contemporary economics holds that the only relevant cost of production is “marginal cost.” As a rule, and roughly speaking, for the concept can only be approximated, “marginal cost” is held to be the cost of the labor, materials and fuel required to produce an additional unit of a product. Their value is supposed to represent the value of the most important alternative goods or services that “society” foregoes in obtaining this additional unit.

The concept of “marginal cost” excludes the cost of existing factories and machines. The reason for this exclusion is that these assets are “here,” they were paid for in the past and, therefore, their cost is not regarded as a concern of “society” in the present.

All prices, according to this view, should be scarcity prices, i.e., prices determined by the necessity of balancing a limited supply against a comparatively unlimited demand.

Supply, in the context of this doctrine, means the goods that are here—in the possession of sellers—and the potential goods that the sellers would produce with their existing plant and equipment, if they considered no limitation to their production but “marginal cost.” Demand means the set of quantities of the goods that buyers will take at varying prices. Every price is supposed to be determined at whatever point is required to give the buyers the full supply in this sense and to limit their demand to the size of the supply.

The essence of this theory of prices is the idea that every seller’s goods and the use of his plant and equipment belong to “society” and should be free of charge to “society’s” members unless and until a price is required to “ration” them. Prior to that point, they are held to be free goods, like air and sunlight; and any value they do have is held to be the result of an “artificial, monopolistic restriction of supply”—of a deliberate, vicious withholding of goods from “society” by their private custodians. After that point, however, the value they may attain is limited only by the importance which buyers attach to them.

On this view, every price is supposed to be an index of the intensity of “society’s” need or desire for a good—an index of the good’s “marginal social utility.”

Thus the tribal view of property, of price, and of cost leads to the view of competition held by contemporary economics.

Competition is viewed as the means by which prices are driven down either to equality with “marginal cost” or to the point where they exceed “marginal cost” only by whatever premium is necessary to “ration” the benefit of plant and equipment operating at full capacity.

This is not competition as it exists in reality. The competition which takes place under capitalism acts to regulate prices simply in accordance with the full costs of production and with the requirements of earning a rate of profit. It does not act to drive prices to the level of “marginal costs” or to the point where they reflect a “scarcity” of capacity. The kind of “competition” required to do that, is of a very special type. Literally, it is out of this world. It is “pure” and “perfect.”

No one has ever defined “pure and perfect competition”—the procedure is merely to present a list of conditions which it requires. A fairly full list of these conditions is presented by Professor Clair Wilcox (who is not an advocate of capitalism) as if it were a definition of “pure and perfect competition.” He writes:

“The requirements of perfect competition are five: First, the commodity dealt in must be supplied in quantity and each unit must be so like every other unit that buyers can shift quickly from one seller to another in order to obtain the advantage of a lower price. Second, the market in which the commodity is bought and sold must be well organized, trading must be continuous, and traders must be so well-informed that every unit sold at the same time will sell at the same price. Third, sellers must be numerous, each seller must be small, and the quantity supplied by any one of them must be so insignificant a part of the total supply that no increase or decrease in his output can appreciably affect the market price. . . . Fourth, there must be no restraint upon the independence of any seller or buyer, either by custom, contract, collusion, the fear of reprisals by competitors or the imposition of public control. Each one must be free to act in his own interest without regard for the interests of any of the others. Fifth, the market price, uniform at any instant of time, must be flexible over a period of time, constantly rising and falling in response to the changing conditions of supply and demand. There must be no friction to impede the movement of capital from industry to industry, from product to product or from firm to firm; investment must be speedily withdrawn from unsuccessful undertakings and transferred to those that promise a profit. There must be no barrier to entrance into the market; access must be granted to all sellers and all buyers at home and abroad. Finally, there must be no obstacle to elimination from the market; bankruptcy must be permitted to destroy those who lack the strength to survive.” (Clair Wilcox, “The Nature of Competition,” reprinted in Joel Dean, Managerial Economics, Prentice-Hall, Inc., Englewood Cliffs, New Jersey, 1951, p. 49. An essentially identical list of requirements appears in the much more recent textbook The Price System by Leftwich and Eckert, op. cit., pp. 39–41.)

To summarize these conditions: uniform products offered by all the sellers in the same industry, perfect knowledge, quantitative insignificance of each seller, no fear of retaliation by competitors in response to one’s actions, constant changes in price, and perfect ease of investment and disinvestment.

To understand the alleged need for all these conditions and what they would mean in reality, it is necessary to project them on a concrete example. This is usually not done at all, and is never done fully—if it were, neither the theory of “pure and perfect competition” nor the rationing theory of prices could be propounded. So I shall use an example of my own, which will not be of a kind used by their supporters, but which will express accurately the meaning of these theories.

Imagine a movie theater with 500 seats. The picture is about to go on; the projectionist, the ushers and the cashier are all in their places. “Society” has the alleged right to the occupancy of 500 seats. If they are not all occupied for this performance, no future satisfaction can be obtained by any storing up of the use of the seats for a future time. The seats, the theater, the film, the necessary workers are “here.” “Society,” supposedly, “has them” and now it demands the full benefit from its alleged property.

If the film is not run, the only thing that “society” can save is the electric current which might be made available elsewhere, or the coal which must be consumed to generate the current. The costs of the theater, the film, the workers are all “sunk costs”—“water over the dam,” as the textbooks say— and, since “bygones are bygones,” the only thing which counts for “society” now is the cost of the electric current.

The theater, according to the tribal-rationing theory, should charge an admission price which will guarantee the sale of 500 tickets for the performance. If droves of people are standing in line for admission, it should raise the price to whatever point is required so that only 500 people will be able to afford it. If all the people in line have identical incomes, the same medical disabilities, and natures of equal sensitivity, such a price, supposedly, will mean that the 500 people who want to see the film most, will see it. If they are unequal in these respects, that is already supposed to be an “imperfection,” as Professor Wilcox would say, in the justice of the “market mechanism.”

If, however, there are few people standing in line, the theater should begin reducing its admission price. It must keep on reducing its admission price until it has attracted 500 customers. If an admission price of only two cents is required to get this many customers, then, supposedly, that is what should be charged, provided only that the revenue brought in at the box office covers the cost of the electric current.

If the theater persists in charging its standard price of, say, one dollar, at which it sells less than 500 tickets, then, according to the tribal-rationing doctrine, it is guilty of “administering” its price and of “monopolistic restriction of supply.” It is engaged in a process of “price control”—in violation of the “laws of supply and demand”—and in creating an “artificial scarcity” of seats by “monopolistically” withholding a portion of its supply from the market to maintain a high price on those seats for which it does sell tickets.

If the theater cannot sell 500 tickets even at one cent per ticket, then, according to this theory, it must either open its doors for free or cancel the performance. In this case, a theater seat is, allegedly, a free good—it is no longer “scarce” in relation to the demand for it, and so there is no longer any need for a price because there is no longer any need to ration theater seats. If there are 100 people who want to see the movie and who are prepared to make it worth the theater owner’s while, he should perhaps run the film—contemporary economics would hold—provided he sells the remaining 400 tickets at whatever price is required to unload them, including zero. This, however, would be another “imperfection” in the “market mechanism”—price discrimination. The “ideal solution” in such a case, it is alleged, would be to have the government nationalize the theater, charge nothing and subsidize the loss.

In the process of adjusting its price to attract customers, the theater must not, of course, send anyone out in the street to tell people about the movie it is playing or the price it is charging. That would be another “imperfection”— advertising. Advertising, according to this theory, is a wasteful and vicious means of “demand creation”—it makes the “consumers” act differently than they really want to act. So, as the theater is reducing its price, it must be careful not to be too obvious about it. Simply changing the price in the cashier’s window should be enough.

However, while advertising by the theater is an “imperfection,” “perfection” requires that all potential customers of the theater possess perfect and instantaneous knowledge of its price changes and of the picture it is showing. It is another “imperfection” in the operation of the “market mechanism” if people about to enter other theaters, or riding in their automobiles, or making love, do not receive instantaneous communication of the price changes, so that they may speedily alter their plans. And, presumably, it is an “imperfection” if they have not already seen all the movies many, many times—to be perfectly informed about them.

Because the theater owner wants to “maximize his profits,” he will not act in accordance with the theory’s tribalistic precepts. However, he would, it is argued, if knowledge were perfect and automatic, if people did race back and forth between theaters in response to penny price differences, and if a number of further conditions were also fulfilled. If, for example, there were 401 identical theaters in the same neighborhood, all showing the same movie, and all in the same position with regard to empty seats, then, it is argued, the cunningly clever, “profit-maximizing” businessman would reason as follows: “At my standard price of one dollar, I can sell only 100 tickets today. But if I charge 99.999 . . .9¢ (it is a standard assumption of the theory that all economic phenomena are mathematically continuous and thus capable of treatment by calculus) I can sell all 500 tickets. For in response to this insignificant price change, which is infinitely close to my present price, I could attract away one customer from each of the 400 other theaters. This would be very good for me, and none of the other theater owners would really notice the loss of just one customer, and thus no one would match my lower price. So that is what I will do.”

The same thought, however, will be racing simultaneously, it is assumed, through the heads of the other 400 theater owners, and so everyone’s price will be trimmed just so much, and no one will end up with any additional customers drawn from other theaters. Each theater may attract one percent of an additional customer who otherwise would not have gone to the movies, but that is all.

The same process is repeated at the infinitesimally lower price, as each theater owner seeks to “maximize his profit,” led by the idea that his insignificant price change will draw an unnoticed amount of business from each of many competitors, who will not reduce their prices in response to his action. This process of infinitely small price reductions is supposedly performed with infinite rapidity—presumably through the “automatic market mechanism”— and so, instantaneously, the price is brought down either to marginal cost or to the point where one’s theater is jammed to capacity, which circumstance alone, in the eyes of the theory’s supporters, would justify the price being above marginal cost.

According to the theory of “pure and perfect competition,” the large number of sellers is the main condition required to drive prices to “marginal cost,” or else to the point where they reflect a “scarcity” of the capacity that is “here.” If the individual seller were a significant part of the market and were in a position to handle a major part of the business done by his competitors, then, supposedly, he would never cut his price because he would know that as a result of his action others will lose so much business that they will have to match his cut and that he will thus be left basically only with the lower price. When there is a large number of small sellers, every price cut is also matched, but, the argument is, not because of one’s own price reduction, but because the other sellers are led to cut their prices independently, guided by exactly the same thought.

The significance of all sellers having an identical product is supposed to lie in the greater responsiveness of customers to price changes. If each theater is playing a different movie, customers are not likely to shift their business among the various theaters in response to infinitesimal price differences, and so a theater owner will have less incentive to trim his price. The significance attached to perfect knowledge is similar.

This portrait of the economic world of perfection is not yet complete, however. There remain two other major requirements if “society” is to derive the maximum benefit from its “scarce resources.” It must be possible, as Professor Wilcox puts it, for investment to “be speedily withdrawn from unsuccessful undertakings and transferred to those that promise a profit. There must be no barrier to entrance into the market . . .” This condition would be achieved if movies were shown in tents, with projectors using candlelight instead of electricity. Then, whenever demand changed, theater owners would merely have to unfold or fold up their theaters, and light or blow out their candles.

This would be “perfection,” but not quite in its full “purity.” For in addition, “the market price,” as Professor Wilcox says, “uniform at any instant of time, must be flexible over a period of time, constantly rising and falling in response to the changing conditions of supply and demand.” This would be achieved if, after leaving the theater and going to a restaurant for dinner, one were not given a menu, but were seated in front of a ticker tape—and were offered a futures contract on dessert; and if afterward, on leaving the restaurant and walking back to one’s apartment, one would not know whether one could afford to live there that night, or whether the rentals of penthouses had collapsed. Only then would the world be “purely perfect.”